02 Utility Functions and Risk Aversion Coefficients Slides

C HOICE T HEORY, U TILITY F UNCTIONS AND R ISK
AVERSION
Szabolcs Sebestyn
szabolcs.sebestyen@iscte.pt
Master in Finance
I NVESTMENTS
Sebestyn (ISCTE-IUL) Choice Theory Investments 1 / 66

Outline
1 An Introduction to Choice Theory

Dominance
Choice Theory Under Certainty
Choice Theory Under Uncertainty
How Restrictive Is Expected Utility Theory? The Allais Paradox
2 Risk Aversion
How To Measure Risk Aversion?
Interpreting Risk Aversion
Risk Premium and Certainty Equivalent
Constant Absolute Risk Aversion
Constant Relative Risk Aversion
Quadratic Utility

An Introduction to Choice Theory
Outline

Dominance
2 Risk Aversion
Quadratic Utility

An Introduction to Choice Theory Dominance
Outline

Dominance
2 Risk Aversion
Quadratic Utility

Preliminaries
Risk means uncertainty in the future cash flow stream

The cash flow of an asset in any future period is typically
modelled as a random variable
Example
Consider the following asset pay-offs ($) with 1 = 2 = 1/2 for the
two states :
t=0 t=1
=1 =2
Investment 1 1, 000 1, 050 1, 200
Investment 2 1, 000 500 1, 600
Investment 3 1, 000 1, 050 1, 600

Dominance
State-by-state dominance: the strongest possible form of

dominance
We assume that the typical individual is non-satiated in
consumption: she prefers more rather than less of goods the
pay-offs allow her to buy
Most of the cases are not so trivial and the concept of risk enters
necessarily
Risk is not the only consideration, the ranking between
investment opportunities is typically preference dependent

Mean-Variance Dominance
In our example, the mean returns and their standard deviations
are
E (r1 ) = 12.5% 1 = 7.5%
E (r2 ) = 5% 2 = 55%
E (r3 ) = 32.5% 3 = 27.5%
Mean-variance dominance: higher mean and lower variance
It is neither as strong nor as general as state-by-state dominance,
and it is not fully reliable
A criterion for selecting investments of equal magnitude, which
plays a prominent role in modern portfolio theory, is
For investments of the same expected return, choose the one with
the lowest variance
For investments of the same variance, choose the one with the
greatest expected return
Sharpe ratio criterion
Example
Consider the state-contingent rates of return with 1 = 2 = 1/2:
=1 =2 E (r)
Investment 4 3% 5% 4% 1%
Investment 5 2% 8% 5% 3%
No dominance in either state-by-state or mean-variance terms

In the mean-variance framework, one would require specifying
the terms at which the investor is willing to substitute expected
return for a given risk reduction
Sharpe ratio criterion: (E/)4 = 4 > (E/)5 = 5/3
However, decisions are again preference dependent

An Introduction to Choice Theory Choice Theory Under Certainty
Outline

Dominance
2 Risk Aversion
Quadratic Utility

Economic Rationality (1)
Economic rationality: individuals behaviour is predictable in

that it is systematic, i.e. they attempt to achieve a set objective
Definition (Preference relation)

There exists a preference relation, denoted by , that describes
investors ability to compare various bundles of goods, services and
money. For two bundles a and b, the expression a b means the
following: the investor either strictly prefers bundle a to bundle b, or
she is indifferent between them. Pure indifference is denoted by a b,
whereas strict preference by a b.

Economic Rationality (2)
Assumptions
Economic rationality can be summarised by the following assumptions:
A.1 Every investor possesses a preference relation and it is
complete. Formally, for any two bundles a and b, either a b,
or b a, or both.
A.2 The preference relation satisfies the fundamental property of
transitivity: for any bundles a, b and c, if a b and b c,
then a c.
A.3 The preference relation is continuous in the following sense: let
{xn } and {yn } be two sequences of consumption bundles such
that xn 7 x and yn 7 y. If xn yn for all n, then x y.

Existence of Utility Function
Theorem
Assumptions A.1 through A.3 are sufficient to guarantee the existence of a
continuous, time-invariant, real-valued utility function u : RN R+ ,
such that for any two bundles a and b,
ab u (a) u (b) .
Remarks:
Under certainty, utility functions are unique only up to monotone
transformations
The notion of a bundle is very general, different elements of a
bundle may represent the consumption of the same good or
service in different time periods

An Introduction to Choice Theory Choice Theory Under Uncertainty
Outline

Dominance
2 Risk Aversion
Quadratic Utility

Introduction
Under uncertainty, the objects of choice are typically vectors of

state-contingent money pay-offs
Those vectors form an asset or an investment
Assume that individuals have no intrinsic taste for the assets
themselves (not really true in practice!), but rather they are
interested in what pay-offs these assets will yield and with what
likelihood
Also assume that investors prefer a higher pay-off to a lower one
Typically, no one investment prospect will strictly dominate the
others
There are two ingredients in the choice between two alternatives:
The probability of the states
The ex-post level of utility provided by the investment

Example
Example
The current price of all assets is $100. The forecasted prices per share
in one period are the following:
Asset State 1 State 2

A $100 $150
B $90 $160
C $90 $150
Which stock would you invest in?

Lotteries
Definition (Lottery)
A lottery is an object of choice, denoted by (x, y, ), that offers pay-off
x with probability and y with probability 1 .
Lottery (x, y, ):
1 y

Example of a Compounded Lottery
Example

Lottery (x, y, ) = (x1 , x2 , 1 ) , (y1 , y2 , 2 ) , :
1 x1

11 x2
2 y1
1
12 y2

Axioms and Conventions

C.1 (a) (x, y, 1) = x
(b) (x, y, ) = (y, x, 1 )
(c) (x, z, ) = x, y, + (1 ) if z = (x, y, ).
C.2 There exists a preference relation , which is complete
and transitive
C.3 The preference relation is continuous
C.4 Independence of irrelevant alternatives. Let (x, y, ) and
(x, z, ) be any two lotteries; then, y z if and only if
(x, y, ) (x, z, )
C.5 There exists a best (most preferred) lottery, b, as well as a
worst lottery, w
C.6 Let x, k, z be pay-offs for which x > k > z. Then there
exists a such that (x, z, ) k
C.7 Let x y. Then (x, y, 1 ) (x, y, 2 ) if and only if
1 > 2
The Expected Utility Theorem
Theorem (The Expected Utility Theorem)

If axioms C.1 through C.7 are satisfied, then there exists a utility function U
defined on the lottery space such that
U (x, y, ) = u (x) + (1 ) u (y)
where u (x) = U (x, y, 1) . U is called the von NeumannMorgenstern

(NM) utility function.

Remarks on the NM Utility Function
Given the objective specification of probabilities, the NM utility

function uniquely characterises an investor
Different additional assumptions on u will identify the investors
tolerance for risk
We require that u be increasing for all candidate utility functions
The theorem confirms that investors are concerned only with an
assets final pay-off and the cumulative probabilities of achieving
them, while the structure of uncertainty resolution is irrelevant
Although the utility function is not defined over a rate of return,
but on pay-off distribution, it can be generalised
The NM representation is preserved under a certain class of
monotone affine transformations: if U () is a NM utility function,
then V () aU () + b with a > 0 is also such a function
A non-linear transformation does not always respect the preference
ordering

An Introduction to Choice Theory How Restrictive Is Expected Utility Theory? The Allais Paradox
Outline

Dominance
2 Risk Aversion
Quadratic Utility

The Allais Paradox (1)
Example
Consider the following four lotteries:
L1 = (10, 000; 0; 0.1) versus L2 = (15, 000; 0; 0.09)

L3 = (10, 000; 0; 1) versus L4 = (15, 000; 0; 0.9) .
Rank the pay-offs.

The Allais Paradox (2)
Example (contd)
The following ranking is frequently observed in practice:
L2 L1 and L3 L4 .
However, observe that

L1 = L3 , L0 , 0.1

L2 = L4 , L0 , 0.1 ,
where L0 = (0, 0, 1).

By the independence axiom, the ranking between L1 and L2 , and
between L3 and L4 , should be identical. This is the Allais paradox
(Allais, 1953).

How to Deal With the Allais Paradox?
Possible reactions to the Allais paradox:

1 Yes, my choices were inconsistent; let me think again and revise
them
2 No, Ill stick to my choices. The following things are missing from
the theory:
The pleasure of gambling; and/or
The notion of regret
The Allais paradox is but the first of many phenomena that
appear to be inconsistent with standard preference theory

Example: Framing and Loss Aversion

Example (Kahneman and Tversky, 1979)
1 In addition to whatever you own, you have been given $1, 000.
You are now asked to choose between
LA = (1, 000; 0; 0.5) versus LB = (500; 0; 1)
2 In addition to whatever you own, you have been given $2, 000.
You are now asked to choose between
LC = (1, 000; 0; 0.5) versus LD = (500; 0; 1)
A majority of subjects chose B in case 1 and C in case 2, but this is

inconsistent with any preference relation over wealth gambles.
The difference between the two cases is that the outcomes are framed
as gains relative to the reference wealth level in case 1, but as losses in
case 2.
Risk Aversion
Outline

Dominance
2 Risk Aversion
Quadratic Utility

Risk Aversion
Introduction
Investors want to avoid risk, i.e., they want to smooth their

consumption across states of nature
Hence, restrictions on the NM expected utility representation
must be imposed to guarantee such behaviour
Since probabilities are objective and independent of investor
preferences, we must restrict the utility function to capture risk
aversion

Risk Aversion How To Measure Risk Aversion?
Outline

Dominance
2 Risk Aversion
Quadratic Utility

Definition of Risk Aversion
Definition (Risk aversion)

An investor is said to be (weakly) risk averse if
u (w) E u (w

e)
for any random wealth w e with mean w. Strict risk aversion is

represented by strict inequality.
An equivalent definition is:
Definition (Risk aversion)

An investor is said to be (weakly) risk averse if
u (a) E u (a + e

) ,
is a zero-mean random variable and a is a constant.

where e
Concavity and Risk Aversion

A risk-averse investor would prefer to avoid a fair bet
The above inequalities are known as Jensens inequality and are
equivalent to concavity of the utility function See Appendix
Concavity is preserved by monotone affine transformations, so,
for given preferences, either all utility functions are concave or
none are
For a differentiable function u, concavity is equivalent to
non-increasing marginal utility:
u0 (w1 ) u0 (w0 ) if w1 > w0
Strict concavity is equivalent to decreasing marginal utility (strict

inequality above)
For a twice differentiable function u, concavity is equivalent to
u00 (w) 0 for all w (strict concavity implies strict inequality)
Concavity and Risk Aversion Intuition
Consider a financial contract where the investor either receives an

amount h with probability 1/2, or must pay an amount h with
probability 1/2 (i.e., a lottery (h, h, 1/2))
Intuition tells us that a risk-averse investor would prefer to avoid
such a security, for any level of personal income Y
Formally,
1 1
u (Y ) > u (Y + h) + u (Y h) = E (u) = U (Y )
2 2
This inequality can only be satisfied for all income levels Y if the
utility function is (strictly) concave

A Strictly Concave Utility Function
Source: Danthine and Donaldson (2005), Figure 4.1

Indifferent Curves

Measure Risk Aversion
Given that u00 () < 0, why not say that investor A is more risk
00 (w)| |u00 (w)| for all wealth levels?
averse than investor B iff |uA B
Let uA (w) auA (w) + b with a > 0
Since the utility function is invariant to affine transformations, uA
and uA must describe the identical ordering and must display
identical risk aversion
However, if a > 1, we have that
00
uA (w) > u00 (w)

A
This a contradiction
We need a measure of risk aversion that is invariant to affine
transformations

Coefficients of Risk Aversion

Absolute risk aversion:
u00 (w)
(w) =
u0 (w )
It depends on the preferences and not on the particular utility

function representing the preferences
For any risk-averse investor, (w) 0
Relative risk aversion:
wu00 (w)
(w) = w (w) =
u0 (w )
Risk tolerance:
1 u0 (w )
(w) = = 00
(w) u (w)

Risk Aversion Interpreting Risk Aversion
Outline

Dominance
2 Risk Aversion
Quadratic Utility

Absolute Risk Aversion and the Odds of a Bet
Consider an investor with wealth w who is offered the lottery

L = (h, h, )
The investor will accept the bet if is high enough and reject if
is low enough
The willingness to accept the bet must also be related to her
current level of wealth
Proposition
Let = (w, h) the probability at which the investor is indifferent between
accepting and rejecting the bet. Then we have that
1 1
(w, h)
= + h (w) .
2 4

Proof.
By definition, (w, h) must satisfy

u (w) = (w, h) u (w + h) + 1 (w, h) u (w h)
Taylor approximation yields
1
u (w + h) = u (w) + hu0 (w) + h2 u00 (w) + R1
2
1
u (w h) = u (w) hu0 (w) + h2 u00 (w) + R2
2
After substitution we have

0 1 2 00
u (w) = (w, h) u (w) + hu (w) + h u (w) + R1 +
2

1
+ 1 (w, h) u (w) hu0 (w) + h2 u00 (w) + R2

2

Proof (contd).
Collecting terms yields

1 2 00
0
u (w) = u (w) + 2 (w, h) 1 hu (w) + h u (w) +
2

+ (w, h) R1 + 1 (w, h) R2
| {z }
R
Solving for (w, h) results in
u00 (w)

1 1 R 1 1
(w, h) = + h 0 = + h (w)
2 4 u (w) 2hu0 (w) 2 4

Example: Exponential Utility
Example
Consider the utility function of the form
1
u (w) = ew

It is easy to show that (w) = .
Hence, we have that
1 1
(w, h)
= + h
2 4
Now the odds demanded are independent of the level of initial wealth,
but depend on the amount of wealth at risk.

Relative Risk Aversion and the Odds of a Bet
Proposition
Consider an investment opportunity similar to the one above, but now the
amount at risk is proportional to the investors wealth, i.e., h = w. Then we
have that
1 1
(w, )
= + (w) .
2 4
Proof.
Very similar to the case of absolute risk aversion.

Example: Power Utility
Example
Consider the utility function of the form
1
w
if > 0, 6= 1
u (w) = 1
ln w if = 1

It is easy to show that (w) = .

Hence, we have that
1 1
(w, h)
= +
2 4
Now the odds demanded are independent of the level of initial wealth.
but depend on the fraction of wealth that is at risk.

Risk-Neutral Investors
Risk-neutral investors are identified with an affine utility function
u (w) = c w + d
with c > 0
It is easy to see that both (w) = 0 and (w) = 0
Such investors do not demand better than even odds when
considering risky investments ( (w, h) = (w, ) = 1/2)
The are indifferent to risk and are concerned only with an assets
expected payoff

Risk Aversion Risk Premium and Certainty Equivalent
Outline

Dominance
2 Risk Aversion
Quadratic Utility

Definitions
Consider an investor, with current wealth w, evaluating an

uncertain risky pay-off Z
e
Relying on the definition of risk aversion, we have
h i
u w+E Z e E u w+Z e
If an uncertain pay-off is available for sale, a risk-averse agent will

only be willing to buy it at a price less than its expected pay-off
Certainty equivalent (CE): the maximal certain amount of money
an investor is willing to pay for a lottery
Risk premium (): the maximum amount the agent is willing to
pay to avoid the gamble
The risk premium is the difference between the expected value of
the bet and the certainty equivalent
Mathematical Formulation
According to the above definition, the certainty equivalent and

the risk premium are the solutions of the following equations:
h i
E u w+Z e = u w + CE w, Z e =

= u w+E Z

e w, Z e
It follows that
e =E Z e =E Z

CE w, Z e w, Z
e or w, Z e CE w, Z
e
Note that from of CE we have that

the definition
u (w + CE) < u w + E Z e
Since u is increasing (recall that u0 > 0), we must have CE < E Z

e

CE and Risk Premium: An Illustration

Example: Certainty Equivalent

Example
Consider an investor with log utility and initial wealth w0 = 1, 000.
e = (200, 0, 0.5). What is the certainty
She is offered the lottery Z
equivalent of this gamble?
Solution
The equation that yields the CE is
h i
E u w+Z

e = u w + CE
Substitution results in
0.5 ln (1, 200) + 0.5 ln (1, 000) = ln (1, 000 + CE)
from which CE = 95.45

Relation Between Risk Premium and Risk Aversion
Assume that E Z

e = 0, u is twice continuously differentiable and
the gamble is a bounded random variable
It can be shown that
e 1
= z2 (w)

w, Z
2
The amount one would pay to avoid the gamble is approximately
proportional to the coefficient of absolute risk aversion
Let = w be the risk premium of w + wZ; e then
1

= z2 (w)
2
The proportion of initial wealth that one would pay to avoid a
gamble equal to the proportion Z e of initial wealth depends on
relative risk aversion and the variance of Ze
Example: Power Utility
Example
1
Consider again the utility function u (w) = w1 with = 3,
e = ($100, 000; $100, 000; 0.5).
w = $500, 000, and Z
Then the risk premium will be
e 1 1 3
= z2 = 100, 0002

w, Z = $30, 000
2 w 2 500, 000
To double-check the approximation, calculate

u w w, Ze = u (500, 000 30, 000) = 2.2634712
e = 1 u (600, 000) + 1 u (400, 000) = 2.2569412

h i
E u w+Z
2 2

Certainty Equivalent in Terms of Returns
Let the equivalent risk-free return be defined as

u w 1 + rf = u w + CE w, Z e
The random pay-off Z e can also be converted into a return

distribution via Z = erw, or, er = Z/w
e e
Hence, rf is defined by the equation

u w 1 + rf = E u w 1 + er
The return risk premium, r , is defined as
r = E er rf or E er = rf + r


Example: Log Utility

Example
Consider the utility function u (w) = ln w, and assume w = $500, 000,
e = ($100, 000; $50, 000; 0.5).
and Z
10% with
Then the risky return is 20% with probability 0.5 and
probability 0.5, and with an expected return of E er = 5%.
The certainty equivalent must satisfy
1 1
ln (500, 000 + CE) = ln (600, 000) + ln (450, 000)
2 2
which implies that CE = 19, 615
It follows then that the risk-free return is
519, 615
1 + rf = = 1.0392
500, 000
The return risk premium is r = 5% 3.92% = 1.08%
Risk Aversion Constant Absolute Risk Aversion
Outline

Dominance
2 Risk Aversion
Quadratic Utility

CARA Utility
Constant Absolute Risk Aversion (CARA): absolute risk aversion

is the same at every wealth level
Every CARA utility function is a monotone affine transform of the
exponential utility function
u (w) = ew
where is a constant and equal to the absolute risk aversion

No Wealth Effects With CARA Utility
With CARA utility there are no wealth effects

h i
Assuming that E Ze = 0, we have that u (w ) = E u w + Z

e
Calculating the two sides yields
u (w ) = ew e e = ew eZe

and u w+Z
Taking expectations and equating gives e = E eZ , from

e
which it follows that

1
ln E eZ
e
=

Hence, an investor with CARA utility will pay the same to avoid a
fair gamble no matter what her initial wealth might be

Normally Distributed Bet
If the gamble Z e is Gaussian, then the risk premium can be

calculated more explicitly
x is Gaussian with mean and variance 2 , then
Recall that if e
1 2
E eex = e+ 2

Now we have e e which has zero mean and variance 2 z2 ;

x = Z
thus the risk premium becomes
1 2
=
2 z

Risk Aversion Constant Relative Risk Aversion
Outline

Dominance
2 Risk Aversion
Quadratic Utility

CRRA Utility
Constant Relative Risk Aversion (CRRA): relative risk aversion
is the same at every wealth level
Any CRRA utility function has decreasing absolute risk aversion
as (w) = (w) /w
Any monotone CRRA utility function is a monotone affine
transform of one of the following functions:
Log utility: u (w) = log w
Power utility:
1
u (w) = w < 1, 6= 0

A more convenient formulation of power utility is
w1
u (w) = = 1 > 0, 6= 1
1
It is easy to show that is the coefficient of relative risk aversion
of the power utility function
Properties of CRRA Utility Functions
Log utility has constant relative risk aversion equal to 1

An investor with power utility is said to be more risk averse than
a log-utility investor if > 1 and to be less risk averse if < 1
The fraction of wealth a CRRA-utility investor would pay to avoid
a gamble that is proportional to initial wealth is independent of
her wealth
Log utility is a limiting case of power utility obtained by taking
1 (by lHpitals rule)

Risk Aversion Quadratic Utility
Outline

Dominance
2 Risk Aversion
Quadratic Utility

Definition and Properties
Quadratic utility takes the form
b
u ( w ) = w w2 b>0
2
The marginal utility of wealth is u0 (w) = 1 bw, and is positive

only when b < 1/w
Thus, this utility function makes sense only when w < 1/b, and
the point of maximum utility, 1/b, is called the bliss point
The absolute and relative risk aversion coefficients are
b bw
(w) = and (w) =
1 bw 1 bw
It has increasing absolute risk aversion, an unattractive property

Quadratic Utility and Mean-Variance Preferences
Quadratic utility has a special importance in finance as it implies

mean-variance preferences
Since all derivatives of order higher than 2 are equal to zero, the
investors expected utility becomes See Appendix
1
E u (w e ) + u00 E (w
e ) = u E (w e ) Var (w

e)
2
Specifically,
b
E u (we ) = 2 + 2

2
For any probability distribution of wealth, the expected utility
depends only on the mean and variance of wealth

A PPENDIX

Some Important Definitions and Results
Concavity and Jensens Inequality

Definition (Concavity)
A function f is concave if, for any x and y and any (0, 1),

f x + (1 ) y f (x) + (1 ) f (y) .
If the inequality is strict, the function is strictly concave.
Theorem (Jensens inequality)

Let f be a concave function on the interval (a, b), and e
x be a random variable
x (a, b)] = 1. Provided that the expectations E (e
such that Pr [e x) and
E [f (e
x)] exist,
E f (e
x) f E (e

x) .
x = E (e
Moreover, if f is strictly concave and Pr [e x)] 6= 1, then the inequality
is strict.
Return
Taylor Expansion of a Function
Definition (Taylor Expansion of a Function)

Let f (x) be a real- or complex-valued function, which is infinitely
differentiable at a point x0 . Then the function can be written as a
power series, called the Taylor expansion of the function, as
f 0 ( x0 ) f 00 (x0 )
f ( x ) = f ( x0 ) + ( x x0 ) + ( x x0 ) 2 +
1! 2!
f 000 (x0 )
+ ( x x0 ) 3 +
3!

Taylor Expansion for the Mean of a Random Variable

Theorem (Taylor Expansion for the Mean of a Random Variable)
x be a random variable with mean and variance 2 (both finite),
Let e and let
f be a twice differentiable function. Then the expected value of f e
x can be
approximated as
E f (e

x) = f () + 1 f 00 () 2 .
2
Proof.
The Taylor expansion of the expected value of f (e
x) is

0 1 00 2
E f (ex) = E f () + f () (e

x ) + f () (e x ) .
2
The expectation of the term containing the first derivative is zero, thus
the expression simplifies to the one presented in the theorem.
Return

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C HOICE T HEORY, U TILITY F UNCTIONS AND R ISK

Sebestyn (ISCTE-IUL) Choice Theory Investments 1 / 66

1 An Introduction to Choice Theory

Sebestyn (ISCTE-IUL) Choice Theory Investments 2 / 66

1 An Introduction to Choice Theory

Sebestyn (ISCTE-IUL) Choice Theory Investments 3 / 66

1 An Introduction to Choice Theory

Sebestyn (ISCTE-IUL) Choice Theory Investments 4 / 66

Risk means uncertainty in the future cash flow stream

Sebestyn (ISCTE-IUL) Choice Theory Investments 5 / 66

State-by-state dominance: the strongest possible form of

Sebestyn (ISCTE-IUL) Choice Theory Investments 6 / 66

Sharpe ratio criterion

No dominance in either state-by-state or mean-variance terms

Sebestyn (ISCTE-IUL) Choice Theory Investments 8 / 66

1 An Introduction to Choice Theory

Sebestyn (ISCTE-IUL) Choice Theory Investments 9 / 66

Economic Rationality (1)

Economic rationality: individuals behaviour is predictable in

Definition (Preference relation)

Sebestyn (ISCTE-IUL) Choice Theory Investments 10 / 66

Economic Rationality (2)

Sebestyn (ISCTE-IUL) Choice Theory Investments 11 / 66

Existence of Utility Function

ab u (a) u (b) .

Sebestyn (ISCTE-IUL) Choice Theory Investments 12 / 66

1 An Introduction to Choice Theory

Sebestyn (ISCTE-IUL) Choice Theory Investments 13 / 66

Under uncertainty, the objects of choice are typically vectors of

Sebestyn (ISCTE-IUL) Choice Theory Investments 14 / 66

Asset State 1 State 2

Which stock would you invest in?

Sebestyn (ISCTE-IUL) Choice Theory Investments 15 / 66

Sebestyn (ISCTE-IUL) Choice Theory Investments 16 / 66

Example of a Compounded Lottery

Sebestyn (ISCTE-IUL) Choice Theory Investments 17 / 66

Axioms and Conventions

The Expected Utility Theorem

Theorem (The Expected Utility Theorem)

U (x, y, ) = u (x) + (1 ) u (y)

where u (x) = U (x, y, 1) . U is called the von NeumannMorgenstern

(NM) utility function.

Sebestyn (ISCTE-IUL) Choice Theory Investments 19 / 66

Remarks on the NM Utility Function

Given the objective specification of probabilities, the NM utility

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1 An Introduction to Choice Theory

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The Allais Paradox (1)

L1 = (10, 000; 0; 0.1) versus L2 = (15, 000; 0; 0.09)

Rank the pay-offs.

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The Allais Paradox (2)

However, observe that

where L0 = (0, 0, 1).

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How to Deal With the Allais Paradox?

Possible reactions to the Allais paradox:

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Example: Framing and Loss Aversion

LA = (1, 000; 0; 0.5) versus LB = (500; 0; 1)

LC = (1, 000; 0; 0.5) versus LD = (500; 0; 1)

A majority of subjects chose B in case 1 and C in case 2, but this is

1 An Introduction to Choice Theory

ab u (a) u (b) .

Note that from of CE we have that